Wednesday, April 11, 2018

Why not taxes?

Reaction to the Washington Post oped (blog post, pdf) on debt has been sure and swift. We suspected we might get criticized by Republicans for complaining about deficits are a problem. Instead, the attack came from the left. Justin Fox hit first, followed by a joint oped by Martin Baily, Jason Furman, Alan Krueger, Laura Tyson and Janet Yellen. It's almost an official response from the Democratic economic establishment.

Their bottom line, really, is that entitlements and deficits are not a problem. They put the blame pretty much entirely on the recently enacted corporate tax cut. (I'm simplifying a bit. As did they, a lot.)

By contrast, we focused on entitlement spending -- Social Security, Medicare, Medicaid, VA, pensions, and social programs -- as the central budget problem, and entitlement reform (not "cut") together with a strong focus on economic growth as the best answer. Our warning was that interest costs could rise sharply and unexpectedly and really bring down the party.

First, let's get a handle on the size and source of the problem.I. Roughly speaking the long term deficit gap is 5 rising to 10 percentage points of GDP. And the big change is entitlements -- social security, medicare, medicaid, pensions.

For example, even Fox's graph shows social security spending rising from 11% of payroll in 2006 and asymptoting at 18%.

The most recent 2017 CBO long-term budget outlook is quite clear. Long before the tax cut that so upsets our critics was even a glimmer in the President's eye, they were warning of budget problems ahead:

If current laws generally remained unchanged, the Congressional Budget Office projects, ..debt...would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation....

Why Are Projected Deficits Rising?

In CBO’s projections, deficits rise over the next three decades—from 2.9 percent of GDP in 2017 to 9.8 percent in 2047—because spending growth is projected to outpace growth in revenues (see figure below). In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt.

The CBO gives us this nice graphs to make the point:

Another CBO's graph follows. Top graph -- where is the spending increase? Social security, health, and interest. Not "other noninterest spending."

(In the bottom graph you see a rosy forecast that individual income taxes will rise a few percent of GDP to help pay for this. Don't be so sure. This comes from inflation pushing us into higher tax brackets and assuming congress won't do anything about it. Notice also how small corporate taxes are in the first place.)

CBO estimates that the 2018 deficit will total $804 billion....[GDP is $20 Trillion, so that's 4% of GDP] ... In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022... Deficits remain at 5.1 percent between 2022 and 2025 ... Over the 2021–2028 period, projected deficits average 4.9 percent of GDP..

Then, things get worse,

In CBO’s projections, outlays for the next three years remain near 21 percent of GDP, which is higher than their average of 20.3 percent over the past 50 years. After that, outlays grow more quickly than the economy does, reaching 23.3 percent of GDP ... by 2028.

That increase reflects significant growth in mandatory spending—mainly because the aging of the population and rising health care costs per beneficiary are projected to increase spending for Social Security and Medicare, among other programs. It also reflects significant growth in interest costs, which are projected to grow more quickly than any other major component of the budget, the result of rising interest rates and mounting debt. ...

And that's only 2028.

You see the problem in our critic's complaint:

"The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending. This year, revenue is expected to fall below 17 percent of gross domestic product."

Let us take the estimate that the recent tax cut cost $1.5 trillion over 10 years, i.e. $150 billion per year or 0.75% of GDP. Compared to the $800 billion current deficit it's small potatoes. Compared to the 5 percent to 10 percent of GDP we need to find in the sock drawer, it's peanuts. (Compared to the $10 trillion or more racked up in the last 10 years it's not huge either!)

[Update: Thanks to commenters, I now notice the "had been expected." OK, we expected 4% of GDP deficits, and then they passed a tax cut and now it's 5% of GDP. Sure. On the day that the tax cut was passed, the entire increase in the deficit was due to the tax cut. But our article, and the economy, is about the overall level of the deficit. The problem is what had been expected, not the recent minor change!]

Here is what the CBO has to say about it:

For the next few years, revenues hover near their 2018 level of 16.6 percent of GDP in CBO’s projections. Then they rise steadily, reaching 17.5 percent of GDP by 2025. At the end of that year, many provisions of the 2017 tax act expire, causing receipts to rise sharply—to 18.1 percent of GDP in 2026 and 18.5 percent in 2027 and 2028. They have averaged 17.4 percent of GDP over the past 50 years.

17, maybe 18. We're waddling around in the 1% range, when the problem is in the 10 percent range. The long run budget problem has essentially nothing to do with the Trump tax cut. It has been brewing under Bush, Obama, and Trump. It fundamentally comes from growth in entitlements an order of magnitude larger.

It is simply not true that "The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending."

To call us "dishonest" -- to call George Shultz "dishonest," in the printed pages of the Washington Post -- for merely repeating what's been in every CBO long term budget forecast for the last two decades really is a new low for economists of this stature. Is Krugmanism infectious?

Put another way, US government debt is about $20 trillion. Various estimates of the entitlement "debt," how much the government has promised more than its revenues, start at $70 trillion and go up in to the hundreds.

To be clear, I agree with the critic's complaint about the tax cut.

"The right way to do reform was to follow the model of the bipartisan tax reform of 1986, when rates were lowered while deductions were eliminated."

Yes! As in many previous blog posts, I am very sad that the chance to do a big 1986 seems to have passed. A large, revenue neutral, distribution neutral, savage cleaning and simplification of the tax code would have been great. There are some elements in the current one -- the lower marginal corporate rate is nice, and there is some capping of deductions, which is why it was a "good first step." But it fell short of my dreams too in many ways.

If only these immensely influential authors had been clamoring for their friends in the Resistance to join forces and pass such a law, rather than (Larry and Jason in particular) spend the whole time arguing that corporate tax cuts just help the rich, perhaps it might have happened. Having to do the whole thing under reconciliation put a lot of limits on what the Republicans could accomplish.

All that aside though, we're still talking about 0.75% of GDP cut compared to a 5%-10% of GDP problem. The long run deficit problem does not come from this tax cut.

II OK, so why not just tax the rich to pay for entitlements?
I hope I have sufficiently dismissed the main line of this particular criticism -- that deficits are all due to the Trump tax cut and all we have to do is put corporate rates back to 35% and all will be well.

On to the larger question, echoed by many commenters on our piece. OK, social security and health are expensive. Let's just tax the rich to pay for it. Like Europe does, so many say.

I do think that roughly speaking we could pay for American social programs with European taxes. That is, 40% payroll taxes rather than our less than 20%; 50% income taxes, starting at very low levels; 20% VAT; various additional taxes like 100% vehicle taxes and gas that costs 3 times ours.

I don't think we can pay for European social programs with European taxes, because Europe can't do it. Their debt/GDP ratios are similar to ours. And their lower growth rates both are the result of this system and compound the problem. Many European countries are responding exactly as we suggest, with deep reforms to their social programs -- less state-paid health insurance, more stringent eligibility requirements and so on.

But that's the option: heavy middle class taxes for middle class benefits, at the cost of substantially lower growth, which itself then drives the needed tax rates up further.

America in fact already has a more progressive tax system than pretty much any other country. Making it more progressive would increase economic distortions dramatically.

A key principle here is that the overall marginal tax rate matters. There is a tendency, especially on the left, to quote only the top Federal marginal rate of about 40%, and to say therefore that high income Americans pays less taxes than most of Europe. But that argument forgets we also pay state and sometimes local taxes.

The top federal rate is about 40%. In California, we add 13% state income tax, and with no deductibility we're up to 53% right there. But what matters is every wedge between what you produce for your employer and the value of what you get to consume. So we have to add the 7.5% sales tax, so we're up to 60.5% already.

But we're not done. The Federal corporate tax is now 21%, and California adds 8.84%, so roughly 29% combined. Someone is paying that. If, like sales tax it comes out of higher prices, then add it to the sales tax. Those on the left say no, corporate taxes are all paid by rich people, which is why they were against lowering them. OK, then they contribute fully to the high-income marginal rate.

What about property tax? The main thing people do with a raise in California is to buy a bigger house. Then they pay 1% property tax. As a rough idea, suppose you pay 30% of your income on housing and the price is 20 times the annual cost (typical price/rent ratio). Then you are paying 6% of your income in property taxes. Add 6 percentage points.

I'm not done. All distortions matter. In much of Europe they charge taxes and then provide people health insurance. We have a cross subsidy scheme, in which you overpay to subsidize others. It's the same as a tax, except much less efficient. In terms of economic damage, and the overall marginal rate, it should be included. If you live in a condo, whose developer was forced to provide "affordable housing" units, you overpaid just like a tax and a transfer. And so on. I won't try to add these in, but all distortions count.

In sum, we're at a pretty high marginal tax rate already. The notion that we can just blithely raise another 10% of GDP from "the rich" alone without large economic damage does not work. This isn't a new observation. Just about every study of how to pay for entitlements comes to the same conclusion.

Again, my argument is not about sympathy for the rich. It is a simple cause and effect argument. Marginal tax rates a lot above 70% are going to really damage the economy and not bring in the huge revenue we need.

Bottom line: Paying for the current entitlements entirely by taxes would involve a big tax hike on middle income Americans.

III Answers

The most important answer is economic growth. 30 years of 3% growth rather than 2% growth gives you 35% more GDP, and thus 35% more tax revenue. If federal revenues are 20% of GDP, that's 7%
of the previous GDP right there. Deregulation and tax reform -- get on with the lower marginal rates and simplification that we agree on -- are important.

(The CBO also writes,

In CBO’s projections, the effects of the 2017 tax act on incentives to work, save, and invest raise real potential GDP throughout the 2018–2028 period....

The largest effects on GDP over the decade stem from the tax act. In CBO’s projections, it boosts the level of real GDP by an average of 0.7 percent and nonfarm payroll employment by an average of 1.1 million jobs over the 2018–2028 period. During those years, the act also raises the level of real gross national product (GNP) by an annual average of about $470 per person in 2018 dollars.

This is not a terrible result!)

Our oped was clear to say social program "reform" not just "cut." Little things like changing indexing and retirement ages make a big difference over 30 years. We argue for reducing the growth and expansion of entitlements, not "cut." Removing some of the very high work disincentives would help people get off some programs. Europe is facing this too, and many countries are a good deal more stringent about qualification than we are.

Our critics say that to point out America cannot pay for the entitlements we have currently promised "dehumanizes the value of these programs to millions of Americans." No. Failing to reform entitlements now and gently will lead to chaotic cuts in the future, on programs that people depend on. If we're going to throw around accusations of heartlessness, denying the problem is the heartless approach.

One factual correction ("I don't think we can pay for European social programs with European taxes, because Europe can't do it. Their debt/GDP ratios are higher than ours"): European debt levels are, in fact, lower than US ones.

A fair comparison requires you to look at general government debt (i.e. states plus federal government). In the US, according to IMF data, this currently stands at 107.8% of GDP. In the Euro Area, 85.6% of GDP (EU as a whole: 82.7%). Of course, there are big differences across European countries, which caused problems for some. But on aggregate, debt is significantly lower, and the difference is forecasted to get bigger (in part due to the US tax cuts).

Still, when the US spends $16 trillion on national security through the Bush and Obama years, and probably another $10 trillion through the eight Trump years ahead (okay, a small joke) and yet we are told we have a "depleted" defense posture...well, I have to think lots of big-time dollars could be whacked off of "national security."

How about a draft? A smaller, spartan military? Can anyone say Vietnam, Afghanistan and Iraq were worth it? So why have a tool that results in counterproductive tar-babies?

The new F35 is not stealthy, and has limited payload, but will cost $1.5 trillion over life of plane. Some fuselages are being built in Turkey. Why Turkey? So they would buy the plane, Are not the Turks in cahoots with Syria and Russia? Yes. Then what is US foreign policy? We did establish an Islamic narco-state in Afghanistan. My tax dollars buck-up opium kings? Make that "very corrupt opium kings."

Sure, if the federal government is willing to accept one my bananas when they tax my bunch of bananas (aka an actual consumption tax), then property and consumption taxes work fine.

Oh, so you want to tax my bananas based upon some "market price" for them? Well, I forgot to tell you that they are all brown and covered with flies.

Property taxes are riddled with problems - problem #1 being that even two very similar pieces of property are never exactly the same. A dollar of income earned here is exactly the same as a dollar of income earned in Alaska or Florida or California. The same can't be said for a 2,000 square foot house in any of these three states.

Excellent post. One correction:Fox's graph shows social security spending rising from 11% of GDP in 2006 and asymptoting at 18% of GDP. It doesn't show that. It's a percentage of taxable payroll, which, I believe is approximately half of GDP.

Social Security IS NOT an "entitlement".It is a program that all WORKING people had no choice but to contribute to, and did so, viewing it as a part of the preparation for life after retirement.It should NOT be viewed as a gift of government

“Had no choice but to contribute to”? That’s what differentiates it from an entitlement? Entitlements are all funded with taxes. Since when do we have a choice on paying taxes? Any many people get back much more than they ever put it. It’s an entitlement.

Science, Guy, obtuse much? Some politicians pinky swore something something AND SPENT EVERY SINGLE PENNY RIGHT THEN! Did they spend the money on the future? No, they spent it on you. Now you think you should get a return on money that you already spent!! Taken from the fica taxes of dishwashers and garbage collectors?!!

It isn't a gift from government because the government doesn't have it's own money!!! It is force. You did not like being taxed so tax everyone else!!!? Two wrongs can never make a right. You make me wish for Carousel.

The most important answer is economic growth. 30 years of 3% growth rather than 2% growth gives you 35% more GDP, and thus 35% more tax revenue. [...]

The CBO also writes [...] "The largest effects on GDP over the decade stem from the tax act. In CBO’s projections, it boosts the level of real GDP by an average of 0.7 percent[...] and raises the level of real gross national product (GNP) by an annual average of about $470 per person in 2018 dollars."

This is not a terrible result!)

---

You are talking about 1% per annum in higher GROWTH RATES for some hypothetical real(TM) tax+reg reform. CBO is saying the last tax act results in LEVEL that will be 0.7% higher on average over the period. HUGE DIFFERENCE. To verify look at the economic projections for June 2017 vs April 2018. Calendar real GDP growth rate 2018 to 2027 averages 1.83% in June 2017 vs 1.95% in Apr 2018. That's a paltry 12 basis points per annum! (And mostly from the first few years as the later years have slightly lower growth rates in the latest baseline, though possibly for reasons not related to taxes.)

Also, the 70 bps higher average level of GDP, as you point out later, comes at a 75 basis point annual cost according to CBO, which given the front loaded GDP increase will be even less beneficial in the subsequent 10 years.

The lack of understanding of basic economics in this post is mind numbing. The truth is US government deficit and debt is not a problem in any way shape or form. In fact, it can be repaid tomorrow without a negative repercussion. That would simply involve replacing government bonds with deposits at the Federal Reserve Bank with similar interest and maturities. The similar or even better risk/reward terms assure no change in investor savings/spending preference or desire to hold dollars. Not recommending this course of action, just pointing out that it is possible.

In fact the Pup just posted a blurb addressing this very issue from an intergenerational equity point of view: http://mmt-inbulletpoints.blogspot.com/2018/04/the-kids-are-not-alright-truth-about.html

Yes. DoDeals keeps making this point, and fails to get "basic economics" that inflating away the debt is the same as default. Just because you can print your currency does not mean that you can pay your debts.

OK Professor. Let's think things through. - Let's say you hold a a $100,000 US govt bond, duration: 10 years, yield: 4%. You get a letter from the Treasury one Saturday morning:"Dear Sir/Madame: We are tired of your whiny bitching and we're paying your asses off. We found a flaw in your documentation, allowing us to prepay, and have decided to replace your bond with a new deposit - fully transferable - at the Federal Reserve Bank under our new Civilian Deposit Program with identical interest and maturity. But because we like you face, we are going to pay you a half point premium so instead of 4%, you will be yielding 4 1/2%.

By the Way: Our Debt/GDP ratio just went from 90% to ZERO. Eat it Dudes!

Best Regards,

The Treasury"

- QUESTIONS: What would you do? Would you freak out? "AAAAaaaahhhh!!!! Zimbabweeee!!!! Weimer Republicccc!!!!!" Would you dump the dollar? Would you buy assets? Trump Tower perhaps, Bitcoin? Would you buy Yuan? If yes, WHY? What has changed? Why would you get inflation? Don't you as a bond/reserve deposit holder still have the same propensity to save as you had earlier that Saturday morning?

To easy. The Fed must have an asset for every liability. If the Fed is to give me $100,000 of reserves, it must keep the $100,000 treasury I give it in return on its balance sheet. Fed owned treasuries are still part of the national debt.

So what's to prevent the Fed from forgiving the Federal Bonds. ("I forgive thee") It records a loss on Bond Investment on its P&L and the Treasury records a Gain on Debt Forgiveness. On a Consolidated basis (Fed + Treasury) its a total wash/non-event. Investor still pretty secure - even more secure since its owed by the entity with he printing press. Easy Peasy!

"To easy. The Fed must have an asset for every liability. If the Fed is to give me $100,000 of reserves, it must keep the $100,000 treasury I give it in return on its balance sheet. Fed owned treasuries are still part of the national debt."

First it's "too" easy, not "to" easy.

Coupon vs. accrual vs. amortized debt?

All U. S. federal government debt is either accrual or coupon debt. Meaning, the federal government never makes a principle payment on a bond until it reaches maturity (unlike amortized debt where interest and principle are paid on a regular basis).

"Ever think that maybe it’s not a linear function? Fed printing works until it doesn’t. Faith is needed. When that faith is lost, things can go pear shaped quickly."

But the faith must ultimately rest on a country's elected representation - not on the central bank. Like I said above, if the central bank buys government bonds while at the same time the federal government reduces the supply of bonds (running a budget surplus for instance), then this will have very little effect on the inflation rate.

FrankAtRest: I don't know what working you are referring to (please quote, I have a day job), but in any event, an amendment to the Federal Reserve Act will definitely be required. - RE: Constitution: Nobody is questioning it. The holder (Fed) would merely forgive.

Professor: Further: You don't need an asset for every liability. If you wrote down the asset to say zero, the offset can be a debit to Capital - or a negative to the equity account, offsetting the remaining deposit amount.

Further still, Professor: If you would have read my MMT blurb ( http://mmt-inbulletpoints.blogspot.com/2018/02/producing-at-full-capacity.html ) you would know that the Step 3 in the action plan is to make the Federal Reserve Bank a part of, and reporting to the Treasury, so the Fed assets and liabilities from/to Treasury get eliminated out and are irrelevant. Once that is understood, all this Nervous Nellie talk about the Federal Debt becomes laughable. Also see the Pup's recent blurb on Intergenerational Equity, the Kids, and the Federal Debt.

I believe DoDeals is correct on this important point. Since the Fed has the assets and the Treasury has the liability the "debt" is gone from the private sector's standpoint - whether it is written down or not.

However, the exercise of swapping Treasuries for bank reserves just puts the government's liability to the private sector in another form - bank reserves - on which interest must usually be paid. I think Mr. Cochrane has made this point in the past.

So, the government (Fed plus Treasury) debt is not eliminated - its composition just changes.

But, if the debt were in the form of, say, bank reserves it would serve the purpose of more clearly demonstrating that the public debt is just a private sector asset - and that the Fed, not the taxpayer, would be paying the interest.

Thus the potential problem of "too much" Federal public debt is not "running out of money', a possible "fiscal crisis", "future burdens", etc. Rather it is the risk of creating too much private sector interest income - which could increase inflation rates if the economy were at full capacity. But, unfortunately, the problem is almost never framed in this manner.

Thus I think DoDeals is correct in that the conventional worries about Federal Debt are not accurate. That conclusion, if correct, changes the tenor of the entire national conversation on this subject! Thank you.

"But, if the debt were in the form of, say, bank reserves it would serve the purpose of more clearly demonstrating that the public debt is just a private sector asset..."

In any accounting, one groups's asset (bonds) is another's liability (debt).

"...- and that the Fed, not the taxpayer, would be paying the interest."

??? Huh. With open market operations, the Fed is a recipient of interest payments from the U. S. Treasury. The Fed can then (at their discretion) remit those interest payments back to the U. S. Treasury. If the Fed choses to remit, then the Treasury in effect pays not interest. If the Fed choses to not remit, then they receive the interest payments and retain them / lend them out.

In no circumstance doe the central "pay the interest on the federal debt".

"Thus the potential problem of too much Federal public debt is not running out of money, a possible fiscal crisis, future burdens, etc."

You are incorrect here. The central bank is under no legal obligation to buy the federal debt (something that DoDeals and other MMT people keep forgetting). So yes, there is a real possibility that the interest payments on the federal debt can exceed the available tax revenue to make those payments.

"Rather it is the risk of creating too much private sector interest income - which could increase inflation rates if the economy were at full capacity. But, unfortunately, the problem is almost never framed in this manner."

Yes, there is this possibility (and it is reflected in the Fisher equation) - higher nominal interest rates (and the associated interest payments) can drive the inflation rate higher given a fixed real growth rate.

"Thus I think DoDeals is correct in that the conventional worries about Federal Debt are not accurate. That conclusion, if correct, changes the tenor of the entire national conversation on this subject! Thank you."

The conventional worry is that the federal government operates with bankruptcy risk - it doesn't. However, given that FOMC / central bank decisions are independent of fiscal policy, the federal government does operate with a cash flow risk (interest expense can exceed available tax revenue).

This comes from the fact that the non-discounted present value of all future tax revenue is infinite (no bankruptcy risk) while the value of the tax revenue collected this year is finite (definite cash flow risk).

Frank Get-some-Rest: RE: "... The Fed can then (at their discretion) remit those interest payments back to the U. S. Treasury. ... ..."• Why would they do that? The payments go to the owners of the deposit - the ex bond holders.

RE: "... All on Thursday, April 12. ... ..."• Some guys play golf. I enjoy shooting fish in a barrel.

RE: "... If you need to change a law (Federal Reserve Act) to make your economic system work, then it isn't much of a system to begin with.... ..."• Really Dude? You're equating amending the Federal Reserve Act with changing the laws of gravity?

Charles:RE: "... the exercise of swapping Treasuries for bank reserves just puts the government's liability to the private sector in another form - bank reserves - on which interest must usually be paid. ...of creating too much private sector interest income - which could increase inflation rates if the economy were at full capacity. ..."• But who controls interest rates? The Fed. So they can set the rate at .00001%

Really, easy peasy, huh? You got about 250+ some house members, 50+ senators, and a president all signed up to support this amendment to the Federal Reserve Act? Name a single U. S. House Member / Senator that has actually introduced a plan resembling this.

Yes, I do. And the question is - do you really think you can make any kind of reasonable economic predictions (growth, inflation, employment) based upon laws that are not in place? That's like me saying I know my mass transport idea will work if only gravity would work the way I want it to.

You remind me of Alan Greenspan - big time supporter of banking deregulation (along with Paul Rubin and Larry Summers).

https://en.wikipedia.org/wiki/Gramm–Leach–Bliley_Act

Of course, when the economic system nearly imploded, his response was:

https://economix.blogs.nytimes.com/2008/10/23/greenspans-mea-culpa/

"Referring to his free-market ideology, Mr. Greenspan added: I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

And this from a guy that has been in the economic / financial world for most of his life. How long have you been at this?

Anonymous: RE: Hyperinflation:- Absolutely not. If we've learned nothing in hte last 10 years its that it's money SPENT not money CREATED that affects prices. And as I've explained to Professor, exchanging reserve deposits for similar bonds won't change propensity to spend. And even if prices did begin to rise, temporary, across the board, and equitable taxes (income, sales/VAT, and asset value) can be applied to cool things off. Easy Peasy!

Frank, I was explaining that: (a)The Fed does pay interest on reserves and (b) if the debt were all in the form of reserves, instead of Treasuries, that then the Fed would be paying all of the interest on the debt. Am I missing something? Thanks.

Yes the Fed does pay interest on reserves. The source of that interest is the interest that it receives on it's bond holdings. And so, the Fed is acting as a pass thru entity - receive interest from taxpayers / government, pay interest to banks that place money on reserve with the Fed.

Mind you, while banks are legally obligated to hold a portion of their assets as reserves, the central bank is not legally obligated to pay interest on those reserve. At any time the central bank could simply stop paying interest and either retain the payments it receives or remit them to the U. S. Treasury.

"(b) if the debt were all in the form of reserves"

You are playing a slight of hand saying that debt (bonds) are replaced with reserves - they are not.

The bonds still exist as legal liabilities to the federal government / taxpayers even when the central bank buys them.

From an accounting standpoint a private bank sells a government bond to the central bank, receives cash for the sale of the bond, places the cash on reserve with central bank, and receives interest payments from the central bank.

Why would a private bank do this rather than just buying the government bond of it's own accord and receiving the interest payments rather than using the central bank as a middle man?

The answer is banking regulation with regard to asset portfolio risk. With reserve requirements, banks are required to hold a portion of their assets in low risk securities.

Frank Thanks much for the comments. Regarding (a: Suppose the Fed forgave the Treasury and wrote off the bonds. The negative hit to the Fed's equity would not look good but it would just be bookkeeping - changing some numbers with no real world consequences. Correct me if I am wrong but the Fed would then continue to pay interest on reserves ("printing" if necessary)- demonstrating my point that when you boil things down - the taxpayer would not be involved.(b)Yes, you are correct - if bonds are all exchanged for reserves - the bonds still exist at the Fed. However, we are all concerned with the debt being some kind of burden for the private sector. The Fed now owns the bonds as an asset. The Treasury has them as a liability. For the government sector as a whole - it is a wash. And from the standpoint of the private sector - the bonds are effectively gone - whether they are written off or not.

In sum, I think this demonstrates that if the bonds are exchanged for reserves, then the bonds are effectively gone and the government liability to the private sector remains - in the form of reserves. It then becomes clear that this 'debt" is no "future burden". It is a private sector financial asset - and the private sector will normally receive interest as well- all at no cost to the taxpayer.

"Regarding (a: Suppose the Fed forgave the Treasury and wrote off the bonds. The negative hit to the Fed's equity would not look good but it would just be bookkeeping - changing some numbers with no real world consequences."

And the "negative hit to the Fed's equity" is more than just a nuisance - it is a legal imperative that the central bank (Fed) does not operate at a loss. Hence the language in the Section 14 of the Federal Reserve Act:

https://www.federalreserve.gov/aboutthefed/section14.htm

"Every Federal reserve bank shall have power:...To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or FULLY GUARANTEED as to principal and interest by, any agency of the United States."

Your statement:

"Correct me if I am wrong but the Fed would then continue to pay interest on reserves ("printing" if necessary)- demonstrating my point that when you boil things down - the taxpayer would not be involved."

The process of the literal printing of money rests under the Bureau of Printing and Engraving, U. S. Treasury. The central bank is permitted to do one of two things:

1. Make short term loans (usually overnight) to private banks (discount window loans).

They are NOT permitted to create deposits without either buying or creating a corresponding private sector liability. In accounting parlance, the loan owned by the central bank is it's asset and a private sector liability. Likewise, the deposits own by a member of the private sector are it's asset and the central bank's liability.

If you think the laws should change (see DoDeals comments), then okay, you are entitled to your opinion.

Your statement,

"However, we are all concerned with the debt being some kind of burden for the private sector. The Fed now owns the bonds as an asset. The Treasury has them as a liability. For the government sector as a whole - it is a wash."

The whole notion of the "government sector as a whole" implies a level of coalescence that does not exist. In the simplest terms, the central bank (as owner of U. S. government bonds) retains the ability to sue the federal government (Legislative / Executive Branches) for payment in the event that payments on the debt are not made.

I am not concerned about that at all, so your "we" doesn't include me. I am concerned about the disincentive effects of guaranteed (interest) income offered by the federal government on it's bonds. I am concerned that interest paid outside the U. S. tax base creates a situation where U. S. "entitlements" are paid to to individuals that lie outside U. S. taxation. I am concerned that the total interest due on government debt can exceed available tax revenue.

Interest paying debt sold by the federal government is the oldest "entitlement" that the U. S. has engaged in surpassing Social Security, Medicare, Medicaid, and the rest by at least 100 years.

Your statement:

"And from the standpoint of the private sector - the bonds are effectively gone - whether they are written off or not."

From a legal standpoint, purchases of government bonds by the central bank do not alleviate taxpayers from the liability associated with them. Like I said above, if you feel that U. S. law should be changed, that's fine. I don't agree, but again you are entitled to your opinion.

Frank: You are way to concerned about laws. The implementation of a Job Gty as part of a Full Employment Fiscal Policy requires changes in laws. Get over it!- http://mmt-inbulletpoints.blogspot.com/2017/09/im-just-responding-to-various-economic.html - http://mmt-inbulletpoints.blogspot.com/2018/04/the-kids-are-not-alright-truth-about.html

Frank Thanks again for the useful comments. You certainly know more about the details than I do. I am looking at things from an macroeconomic viewpoint, not from a legal standpoint. That is, actions which could be taken with, if necessary, a change in the laws.

So, for example, if the Fed owns Treasuries as an asset and the Treasury has them as a liability, these securities are effectively gone from the standpoint of the private sector - and for the government sector as well.

If the Treasury wishes to pay the Fed interest and then the Fed ships most of the interest back to the Treasury, as is the current practice - fine - but the effect is basically the same as would be the impact if the securities did not exist in the first place.

I'm still not clear as to interest on reserves. I assume that if the Fed has "no money" - it still would pay interest on reserves - this money would be created out of thin air - as the Fed did when implementing QE. Any help appreciated.

----I said that the Fed could forgive the Treasury and then just change some numbers in a spreadsheet and the debt the Fed held would be gone. It would just be bookkeeping. I think this is different from, say, the BEA compiling GDP, etc. In the latter case, they are keeping tabs on the stocks and flows of real goods and services - the real economy - an important activity as you note.I could be wrong, but I think my proposition is more analogeous to the BEA ,say, reclassifying an activity from one part of GDP to another. This would just be helpful "bookkeeping" but with no impact on the real economy.

"That is, actions which could be taken with, if necessary, a change in the laws."

And that is fine. I take some umbrage with individuals that claim to predict economic outcomes based upon changes in law (see the Greenspan lesson).

"If the Treasury wishes to pay the Fed interest and then the Fed ships most of the interest back to the Treasury, as is the current practice - fine - but the effect is basically the same as would be the impact if the securities did not exist in the first place."

But it's not exactly the same because of choice. When the securities exist, the central bank can choose to remit those interest payments under one administration and then choose to retain those interest payments under another administration.

That can create a toxic economic atmosphere - if there is the appearance of favoritism on the central bank's part - even if economic conditions warrant that the remittances should be suspended / restarted.

"I'm still not clear as to interest on reserves. I assume that if the Fed has no money - it still would pay interest on reserves - this money would be created out of thin air - as the Fed did when implementing QE. Any help appreciated."

When implementing QE, the central bank did literally create money out of thin air to buy government bonds and mortgages - which, by law, they are permitted to do - although the purchase of mortgages was and may still be on shaky legal grounds.

Please understand, our credit monetary system is designed to both expand and contract. When the central bank buys a government bond, the intent is that over time that the money used to buy the bond will eventually be returned to the central bank in the form of interest or at the very least principle repayments. And so QE ultimately represents a "temporary" monetary expansion.

Contrast that with the central bank "printing" interest payments. In that case the monetary expansion is permanent for all intents and purposes. There is no corresponding liability that is designed to undo the monetary expansion.

Once the Fed buy those government bonds, it can do one of several things with the interest payments that they receive on those bonds.

1. The Fed can choose to remit those interest payments back to the U. S. Treasury2. The Fed can choose to send those interest payments to private banks that maintain reserves with the Fed3. The Fed can choose to retain those interest payments until a later date

Interest on reserves began after QE and will likely be terminated prior to the Fed reducing it's balance sheet back to pre-recession levels. And so the Fed will always have money to pay interest on reserves from the Treasury / mortgage bond interest it receives as long as it's balance sheet remains enlarged.

"I could be wrong, but I think my proposition is more analogeous to the BEA ,say, reclassifying an activity from one part of GDP to another. This would just be helpful bookkeeping but with no impact on the real economy."

Okay, that is what I thought you were getting at. What I believe you are referring to is financial transactions (money for bonds / stocks) vs. real economy transactions (money for cars or airplanes or some other physical good). I am running of allowable typing space, so if that is the case I can discuss in a later post.

Frank thanks for the insightful comments. For example, useful observation that if the Fed sells its bonds, it will lose the interest income. But, if excess reserves have been largely eliminated at that point, it will no longer need to pay interest on reserves to maintain its target rate. So the effects are offsetting and not a big deal. Sorry for delay. You still have not convinced me that the debt is an issue. That the Fed could just buy it all back and then pay interest on reserves out of thin air. But thanks for trying. I'll think about your comments.

- All this talk RE: interest payments is a distractor. Totally irrelevant. The point is the Fed can be consolidated and made part of the Treasury. So the debt is a total nothingburger. - Yes indeed, newly created money does not self immolate. Its out there, but can certainly be destroyed via taxation if it ever contributes to inflation.

Issue #1a. Incentives - Government debt ultimately constitutes future expenditures by the federal government paid out of tax revenue in the form of interest payments. These expenditures are guaranteed by law and as such are a form of entitlement. If entitlement reform is of any concern, then limiting (or eliminating) the amount of interest paying U. S. debt should be part of that discussion.

Issue #1b: Federal government entitlement reform becomes doubly complex when payments are made to beneficiaries who have not contributed to the entitlement system via taxes. Consider if the U. S. started making Social Security or Medicare payments all over the world while having U. S. tax payers pick up the tab.

So at this point you might be saying - fine, have the central bank buy up all of the government debt, which leads me to:

Issue #2a. Central bank independence from fiscal measures - A central bank should be able to formulate and exercise monetary policy independently of fiscal stance. That process is complicated and can be made impossible by a federal government that is unwilling to reduce / contract the growth rate of it's outstanding debt.

Item #2b. Fiscal independence from central bank measures - Everyone talks about central bank independence, but this is really a two way street. Fiscal policy becomes easier to maintain over a significant enough time frame to matter when debt concerns are eliminated (see Reagan / Bush II tax policy).

Let me use a crude example to explain why central bank independence is important. Which type of motor vehicle control would you rather have:

1. One lever that controls both velocity and turn radius2. Two levers - one control for velocity (accelerator / brake) and another for turn radius (steering wheel)

When governments don't borrow (independent central bank), you get both an accelerator / brake and a steering wheel.

When governments borrow (central bank acquiescence) you get either an accelerator / brake or a steering wheel (but not both).

Consolidating the central bank within the federal government ultimately puts you in a situation where you are driving with one lever.

I can't explain it much better without using a whole bunch of math equations.

Frank Thanks for all the information. I agree in that in the real world the Fed is separate from the Treasury and that's fine the way it is. I'm just saying that by thinking about them on a consolidated basis, you can get a clearer picture of how the government sector (Fed plus Treasury) is impacting the non-government (private) sector.So, to be repetitive, if the Treasury has securities as a liability and the Fed has them as as asset, I still think they are effectively gone from the standpoint of the private sector.

Yes, you are correct in that you could say the taxpayer pays the interest to the Fed. But when the Fed ships the interest back to the Treasury, the taxpayer is getting the money back. This taxpayer money is spent, of course, but, at the end of the day, it is logically not being spent on interest - but on something else. At least in my humble opinion.Thanks.

Frank, Thanks again. Yes, good point. That "something else" could well be interest as you point out. But it would not be the interest on the bonds held by the Fed. Yes, also good point that Fed remittances do not exactly equal Treasury payments to the Fed. Among other things, the Fed uses some of the money for operating purposes. But that's splitting hairs based on government accounting - not the economic reality that the "government" has the bonds as both an asset and a liability - so why should anyone care?

Absent legal issues, the bonds could just be cancelled and no one would know the difference. You apparently disagree. Fine. Thanks for the helpful insights.

Yes, the problem is entitlements. More succinctly, the nth stage of economic consequences resulting in cascading negative economic consequences. Cascading negative economic consequences resulting from a notional political proposition(s) based on first stage economic consequences. Further, the original sponsoring politicos of the notional propositions pay no direct price for the failure...current and future taxpayers pay the price.

'It is simply not true that "The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending." '

Correct. However, if additional tax revenue is needed a viable option is to tax shallow economic analysis such as that which recently appeared in a Washington Post op-ed. Armen Alchian they are not!

(1) For twenty years the American right has been pursuing "starve the beast": "first we bankrupt government through tax cuts then use the resulting crisis to cut the entitlements which we oppose on ideological grounds". Sounds like you have reached the end game on that. If you don't like the end game, take it up with Grover Norquist.

(2) Five percent of GDP is unpleasant but not an existential crisis. Americans consume more than they produce and that is going to have to stop.

(3) Growth will not save you. If GDP per capita goes up, e.g., 30% then Baumol's effect will mean that salaries for doctors, nurses, care workers and administrators (and hence the cost of labor intensive health care programs) will go up about 30%.

(4) Research on cost effectiveness of treatments would probably help but the Republicans opposed it saying it would be "death panels". Reducing the cost of health care would help.

I will add that criminal justice reform has to potential to give the United States higher labor force participation for prime age men which would help a little bit with bringing production / taxes / entitlements / consumption in line. IIRC the United States has the lowest prime age participation rate among developed countries and part of that may be a result of how your criminal justice system works.

In your post you failed to mention Bush tax cuts and two wars. Vox.com did a more thorough analysis here: https://www.vox.com/2018/4/10/17215440/deficits-rising-congressional-budget-office-ceo-debate . They show an illuminating plot showing Bush tax cut effect on the deficit. So if you put it together it's not the entitlements, it's by far the tax cuts.

Visit the CBO's website and draw your own conclusions: https://www.cbo.gov/about/products/budget-economic-data. You may discover Vox's analysis is a bit misleading.

More to the point though: if robust entitlement spending is your position (which is fine!), and that higher taxes are the sole answer (also fine!), then you need to accept that the tax increases required will be a whole lot bigger than just rolling back the Bush/Trump tax cuts. You'd need to set federal revenue to something like 23.5% of GDP, which is MUCH higher than taxes have ever been in the modern fiscal era (hit that CBO website if you don't buy my numbers). Maybe that's fine, but can you at least appreciate why it makes some folks a bit nervous?

As republics morph into democracies it appears their elected leaders end up in a race to the bottom of making promises that the government/society eventually can not repay.

Yes it would be nice if the leaders were responsible but that’s not the behavior the voters and the system rewards. Either the system of governence gets fixed at a deeper level or the system continues down the tracks to the end of the line which is some level of default.

Timothy: This is of course nonsense. If the govt had implemented a Job Gty as part of a Full Employment Fiscal Policy, there would be no pressure to provide anything. Everyone would be working. And nobody likes inflation. (Except Austrians smoking too much weed and imagining it.) And issuing currency to hire unemployed folk does not produce inflation since business people go waky waky and produce more goods and services - offsetting the newly issued currency.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!